Wednesday, April 26, 2017

Lesson #264: Financing Mergers & Acquisitions

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We have previously talked about How to Set Your Mergers & Acquisitions Goals. But, once those goals have been set, and targets have been identified, how exactly do you fund those transactions? As you will read, financing M&A activity is very different than funding stand-alone growth with venture capital, as the investors are largely very different--mostly banks, private equity firms and family offices, instead of venture capital firms. This post will help you better learn your M&A financing options.

EQUITY ONLY--NO CASH NEEDED

M&A activity doesn't always mean that cash needs to trade hands. Sometimes you can implement a merger by basically using your equity as a currency, and negotiating a pro rata stake in the combined company. For example, if you have two equal sized businesses both valued at about the same valuation stand-alone, you can merge the companies together and your original shareholders would own 50% of Newco and the other company's shareholders would own the other 50% of Newco. If they are not the same size, use a metric like relative revenues or relative EBITDA and set the relative ownership that way (e.g., if one business generates 75% of the combined profits day one, they could own 75% of the combined equity in Newco).

CASH ON HAND OR COMPANY PROFITS

If cash is needed, maybe your business has cash on its balance sheet or it is generating material profits, and you can fund your M&A activity that way, with no outside capital. Since companies are typically valued as a multiple of EBITDA, you may need to save up a few years of profits, in order to afford the other company you are trying to buy, if they are the same size as you.

SELLER NOTES

The easiest way to finance an M&A transaction is to have the seller agree to not take all of their cash up front. As an example, maybe you pay them 80% at closing, and you pay them 20% in a seller note a year or two down the road. Any seller that has confidence in their business, should be willing to agree to at least a small amount of seller note to help you afford the upfront transaction.

SELLER EQUITY

In many scenarios, having the seller involved with the future of Newco can be very helpful. Maybe you don't know their industry very well? Or, they bring some specific skillset to the table, and they would enjoy keeping part ownership and future involvement in "their baby". That helps them to get some upfront liquidity by selling a large portion of their ownership, but at the same time, let's them participate in the long term growth that is created, as a minority shareholder. So, as an example, if you give the seller a 10% stake in Newco, you only need to fund the 90% of the company's valuation upfront.

BANKS & SBA BACKED LOANS

Banks are often the first call for funding M&A. But, with banks, there are several hurdles you need to get through. They need to like the industry, the team, the historical cash flow trends, the underlying assets of the business they can secure, the financial covenants, etc. And, the more cash flow you have as a combined company, the higher odds a bank with lend to you. There are some banks that will lend to companies as small as $500K of cash flow, but the vast majority don't really get excited until you are generating $2-$3MM in cash flow. So, look for targets that can help you get to that threshold, to simplify your M&A fund raising efforts. And, keep in mind, bank finance will be the most senior loan in your capitalization table, and banks will need to be repaid within a couple years (and will be senior to any other note holders, including the seller note above). So, plan accordingly.

In addition, the banks are often conduits to loans backed by the Small Business Association, where they will lend up to 90% of the transaction. But, the price is steep with the mandatory personal guarantees that will be required, putting you personally on the hook for any defaults by the company. Personal guarantees can often be avoided in typical bank loans for companies generating enough annual cash flow, so only go down the SBA-backed road if it is your only option.

PRIVATE EQUITY FIRMS

The lion's share of the capital needed for M&A will most likely come from private equity firms or family offices, likes these linked examples in Chicago. There is a shortage of really good companies for sale, and these investment companies are more than willing to back good teams building good ideas, assuming the combined company is generating a lot of cash flow (which they can take to the banks and finance a portion of the deal with debt, to reduce their equity investment need). Again, because they are looking to the banks for help, they too will bias companies with over $2-$3MM of combined cash flow (although many will look at deals smaller than this, if only investing equity). Before you reach out to PE firms, make sure to research if they like to invest in deals within your industry and revenue stage on their websites.

EXAMPLE DEAL

So, let's put this all together in an example deal. Let's say you found an ecommerce company to buy, that is generating $2MM in cash flow. Assuming that company is growing 20% a year, it could be worth 5x cash flow, or $10MM. You think it is important to keep the founder involved, and you are willing to have him take a 10% stake in Newco, so you really only need to finance $9MM to buy the 90% stake. That could be funded $3MM by a private equity firm, $3MM by a bank and $3MM by a seller note (if amenable to the seller). And, the private equity firm would most likely want you to have some "skin in the game", so maybe their portion is split $300K from you and $2.7MM from them. Ninety days and lots of negotiations later, you should be ready to close. This is an example only, as the multiples, amounts and percentages can vary substantially by deal, company, growth rate and industry.

Hopefully, you are now ready to put on your M&A hats, and get that transaction funded. But, don't forget about all the potential M&A pitfalls along the way, as we have discussed in the past. At all times, buyer beware, and exercise conservative caution throughout each step of the process.

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